Against the Grain

passive investing.

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I need to tread lightly in this post for a few reasons, not the least of which is that there is overwhelming evidence that a long-term passive index investment strategy has significantly outperformed active investment managers (including mutual funds and hedge funds) over the past several years. In fact, I feel so uncertain about this post that I have to rely on a cute picture of one of my children to market the post!

Below is a passage from a Forbes article in August 2013 succinctly summarizing the data on active vs. passive investing:

“Using Morningstar’s fund database, we examined the performance of more than 2,000 active US equity funds during the 15-year period from July 1, 1998 to June 28, 2013. Result: only 25.6% of the active funds currently in existence outperformed their benchmarks (nearly 75% trailed the benchmark or had an insufficient track record to compare). Many other studies over extended time periods have reached a similar conclusion, including Standard & Poor’s, which found that 69% of all domestic equity funds were either outperformed after expenses by their benchmarks over the prior five years or had been liquidated during the period from Jan. 1, 2008 to Dec. 31, 2012 (Source: S&P Indices Versus Active Funds Scorecard).”

I don’t dispute the data. I also would never claim to be smarter than the average professional investor. But I truly believe that we are at a point where smart, active investment strategies grounded in value-investing principals are going to crush the index returns over the next twelve months, provided the fees are reasonable. The rationale boils down to timing- passive strategies tend to do their ass-kicking relative to active strategies in strong bull markets vs. sideways/ bear markets. And with the huge institutional investors like CalPERS now abandoning active investment managers for ETF’s, it will drive down the fees that active managers will charge and create opportunities for smaller investors to partner with the better active managers.

For everyone’s sake I hope the market continues to climb steadily, but muted GDP and real wage growth suggests we have a lot of catching up to do in justifying a continued stock market climb. The U.S. economy and stock market has amazing advantages relative to other investment options in the world due to job growth, a strong dollar and oil production, amongst other factors, but in the end it’s hard to build an argument for outsized U.S. stock market returns next year. There are still plenty of legitimate headwinds for continued growth- continued deficit woes, ineffective government, historically low labor participation rates, European stagnation, military instability via ISIS and Russia/ Ukraine, not to mention future problems from countries like Venezuela if oil prices spark political instability. Don’t get me wrong- I’m still bullish on the American economy in particular- I just think healthy investment returns over the next 12 months will require a manager who knows how to pick the right spots vs. the consensus view of an a passive index approach.

Recently Bloomberg published a great article about the demise of many hedge funds in light of their under-performance to passively-managed portfolios. Specifically, it references that through June 2014, 461 hedge funds had closed shop, the worst year for hedge fund closures since 2009. Check out the link for a full flavor of their perspective and video dialogue on the commentators’ perspective:

At the end of the day, I don’t have a crystal ball. But I do have my own personal investing experience over the past 20 years and gut intuition to believe that the current passive investing and ETF craze feels a bit like a bubble to me, despite ample amounts of credible evidence to the contrary.

Intuitively, how on earth can a competitive market be set for the fair value of investment securities if the majority of investment capital is being funneled via a passive vehicle that pays no heed to the intrinsic value of the asset? In other words, an asset needs to be rationally valued somehow- the less that the value is determined by informed investors vs. index allocations, the more that opportunity arises for smart, active investors who can pick their spots.

Did I mention that the ATG Fund will be open to outside investors January 1, 2015? Let me know if you are interested in learning more about the ATG investment fund and our specific strategies for 2015.